See also:General Index of all guest columns written by Dennis C. Butler, CFA

Franklin
Roosevelt's New Deal may have rescued capitalism from an earlier generation
of capitalists, but who or what will save it from our present-day captains
of industry and finance? Some members of our Great Recession-era corporate
elite share with their Great Depression-era forebears a shameless sense of
entitlement and an inability to resist opportunities to demonstrate their
detachment from and incomprehension of the world as most people know it.
Now, as in the 1930s, the behavior of some who have reaped great personal
benefit from their positions at the top of the corporate hierarchy is sowing
resentment over capitalism's wealth distribution inequities, even among
people who acknowledge the system's advantages over other forms of economic
organization.

Excesses that came to light at the height of the financial crisis in
2008-2009 — million-dollar office remodelings, Riviera villas, and personal
fortunes that survived the collapse into bankruptcy of
long-standing enterprises — continue in
spite of the glare of publicity. A notable recent example involves the head
of a major U.S. bank who accepted a sizable bonus payment despite the fact
that his institution incurred billions of dollars in losses and fines on his
watch. When asked about the bonus at a congressional hearing, his response
was "It's up to the Board."  Another executive, this time at a European
company, caused an uproar when, after only three years on the job, he
received $25 million for simply selling the company to a former employer — $1 million for each $1 billion in
equity market value lost during his tenure, critics pointed out.

The ultimate offence to the
sensibilities of anyone except members of the unreconstructed managerial
class came from the chief executive of a bailed-out insurance company who
compared attacks on the corporate "bonus culture" to the lynchings of
African-Americans in the American South decades ago. Comparing the injured
self-pride of a whining, privileged elite to the murder of innocent
individuals brought a well-deserved harsh response and hasty apology from
the whiner in question. Our own preference would be for this particular
tone-deaf executive to take his bonus, retire to his Elysium,
and not be heard from again. However, while that would clear the air of one
annoyance, it would not solve the problem of a system that spawns more of
his ilk on a continuous basis.

It is not that we are
anti-capitalist, quite the opposite, in fact. The compensation practices and
attitudinal issues noted above not only give capitalism a bad name, but are
also self-defeating and potentially costly to the extent that they increase
support for more restrictive regulation of business, as we see in the
financial sector. Moreover, our defender of the bonus culture either
misunderstands the critique, or attempts to obfuscate the issue. It is not
the big cash payoffs per se that are a problem; it is the too-frequent
absence of a clear link between these vast payments and job performance that
rankles. Make no mistake about it —the awards
arevast. The average American taxpayer earns roughly $2 million over the course
of a lifetime.
It has not been unheard of for a payoff equaling 100 times
average lifetime earnings to be granted for
failure.

Perhaps we are too
idealistic. We believe that under a well-functioning, competitive
capitalism such as that envisioned by Adam Smith, these excesses would be
far less likely. Instead, what we have is greatly removed from the
competitive ideal — a kind of crony corporatism whose out-of-control
practices not only invite unwanted attention and counterproductive
regulatory intervention, they effectively short-circuit capitalism's own
powerful and relentless self-regulatory mechanisms, a key one being
"creative destruction." Creative destruction —
the cost of failure — is, as
one financial writer succinctly put it, "capitalism's way of ensuring that
capital no longer flows to businesses that cannot put it to good use."  It is
largely responsible for capitalism's successes, and also for the opprobrium
it engenders among those who suffer its ill effects through lost employment
and livelihoods. The people who run businesses need to fear suffering the
same fate. They should be no more insulated from the downside of creative
destruction than are the business owners —
the shareholders of public companies — who are subject to the risk of irretrievable loss. A system that
rewards short-term results, or even failure, does just that.

We
have long advocated that corporate leaders be exposed to partnership-type
risks under which their rewards would be accumulated over time, tied to the
long-term health of the business, and only be accessible well after their
departure or retirement from the enterprise. We are under no illusion that
this sort of reform will take place anytime soon owing to the almost certain
political and legal roadblocks that opponents would employ. Additionally, we
are skeptical that more direct interventions into corporate governance —
such as regulating compensation — would work; such steps can be evaded, as they have been in
the past. In addition, what criteria should be used to guide "appropriate"
compensation? It would be far better to foster a genuinely open and
competitive market for management services and shine light on a process now
dominated by self-interested consultants. Along those lines, the SEC's
proposal to publicize relative compensation levels within companies is a
step in the right direction, as are efforts by some in fund management to
pressure corporate boards into adopting long-term incentives and rewards for
executives (one hopes these policies also apply to the fund managers
themselves). It is to be hoped that unleashed market forces will be given a
chance to operate, since it is clear that not even shaming works for
champions of the bonus culture.

***

During times when most investors are making money,
not too many care about the take-home pay of pampered executives. This is
one of those times. In fact, with the exception of some hedge funds, gold
bugs, and short-sellers, most Americans directly or indirectly through
retirement plans have benefitted from a remarkable 20% rise in average
equity prices so far this year. Continuing the rebound from 2009, market
indexes have set new records, at least on a non-inflation-adjusted basis.
Fixed-income activity continues to show noteworthy strength as well, as
September's record $49 billion bond sale by a single issuer —
double the previous record set earlier this year — attests.

Contributing to the market gains are central bank
policies, which were reinforced by the Federal Reserve's unexpected
announcement after its September meeting that "quantitative easing"
operations would continue unabated. Rises in security prices are one
mechanism by which monetary policy feeds through to the "real" economy. A
"wealth effect" encourages spending, thereby stimulating demand. That there
appears to be a disconnect between market action and recent economic
performance is likely a timing issue; central bank actions work with a lag,
and the normal gap between policy measures and business activity has been
exacerbated by the worst economic contraction in 80 years, a downturn that
weakened banks and damaged individuals' incomes and balance sheets.

Given the severity of the retrenchment, it would take
a while to recover even under normal circumstances, and current conditions
are far from normal. Appalling governmental incompetence and its impact on
fiscal policy at the Federal level has already put a damper on consumer
behavior and business investment spending. A lengthening government shutdown
and threatening debt default would create unstable conditions, especially if
the latter should come to pass. The immediate future, it would seem, holds
some potential excitement in store. Long-term the U.S. has the advantage of
tremendous wealth and economic stability, but a default resulting from a
political impasse would call into question the country's ability to marshal
those resources to meet its obligations, upending a 225-year history of
reliable debt payment.

As investors we must always deal with the world's
vicissitudes on a macro, micro, and issuer level. The current circumstances,
while seemingly intractable, are no worse that others we have faced and
certainly not as dire as past emergencies. As the business media constantly
remind us, we may have to deal with increased market "volatility" as if
that were a risk. For us, simple fluctuations in security prices, especially
when they are of significant magnitude, mean opportunity, as history has
shown time and again. If such expectations indeed come to pass, we plan to
act accordingly.

_____________

Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 27 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.

"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at: